Week of 11/6/11

November 8, 2011

ECB: Friend or Foe?

Mohamed El-Erian: “There is only one institution that has an immediately-available balance sheet that could stabilise the situation in the next few days and weeks — the ECB. … [but it] needs others to help on four critical issues: a bold and lasting separation in how we deal with Europe’s insolvent nations and its illiquid ones; a regional programme to enhance growth and employment; immediate actions to counter the fragility of the banking system; and bold political decisions to strengthen the institutional underpinning of the eurozone.”

John Quiggin: “This failure has been caused by the policy choices of one of the few European institutions that has the capacity to act unilaterally and decisively: the ECB. … [It] has pursued a ‘one size fits nobody’ policy of monetary contraction, at a time when no European economy is growing strongly. … Unlike any previous central bank in history, the bank has disclaimed any responsibility for the European financial system it effectively controls, or even for the viability of the euro as a currency.” — 11/10/11

CRISIS: Italian Yields Over 7 Pct

Italian sovereign bond yields surged beyond the critical 7-pct demarcation line overnight. That’s the line considered to separate sustainable debt costs from unsustainable, and now Italy — a G8 member that is the EU’s third largest economy and the world’s eighth — has crossed into the unsustainable zone. The ECB engaged in emergency bond buying in an effort to avert catastrophe for Rome and the entire EU.

Nouriel Roubini thinks “markets are telling [Italian PM Silvio] Berlusconi to leave now. They don’t buy his scheme of pretending to leave in two weeks after a budget is passed.” Not that political shuffling will do much. Barclays analysts believe Italy is “now mathematically beyond the point of no return,” that reforms will “not be enough to prevent crisis,” and that “growth and austerity [won’t be] enough to offset the cost of debt.” Martin Wolf suggests that the EU needs to make widespread adjustments that risk inflation, or break up. — 11/9/11

Italian Bonds Toe The Red Line

The EU’s new plan has done nothing but push Italian bond yields higher. You read here last Friday, “Italian yields are now over 6.35 pct — their crisis-high region, where they began August, and you may recall what a swell month that turned out to be.” Now Italian yields are 6.66 pct. CNNMoney: “The 7 pct level isn’t an automatic bailout trigger but it is the level that prompted bailouts for Portugal and Ireland. Even though those countries share PIIGS status with Italy, they’re tiny in comparison. Keeping Italian bond yields under 7 pct is essential because unlike Greece, Italy is too big to bail out. … Italy is the third-largest economy in Europe, behind Germany and France, and it has one of the largest bond markets in Europe.” Italian PM Silvio Berlusconi is under pressure to step down because he has not delivered economic reforms he promised. CNBC reports the ECB may not continue its bond-buying program that’s helped hold down yields since summer. “Yves Mersch, a member of the central bank’s Governing Council, warned in an interview with Italian newspaper La Stampa on Sunday that it could stop buying Italian bonds if Italy fails to take appropriate action over its debt.”— 11/8/11

EU Banks Very Exposed

WSJ: “European banks are sitting on heaps of exotic mortgage products and other risky assets that predate the financial crisis, adding to pressure on lenders that also are holding large quantities of euro-zone government debt. …

“Sixteen top European banks are holding a total of about €386B ($532B) of potentially suspect credit-market and real-estate assets, according to a recent report by Credit Suisse analysts. That’s more than the €339B of Greek, Irish, Italian, Portuguese and Spanish government debt that those same banks were holding at the end of last year, according to European ‘stress test’ data.” — 11/8/11

US Banks Cook The Books

S&P is displeased with a US accounting rule that allows banks to chalk up earnings gains when their own creditworthiness deteriorates, and usually report them as credit valuation adjustments (CVAs) or debit valuation adjustments (DVAs).

FT Alphaville: “The credit deterioration of Bank of America, for example, was responsible for the entirety of its reported net income. For JPMorgan Chase and Citigroup, it provided a profit boost. … For Goldman Sachs and Morgan Stanley it offset further losses. All in all, a nice cushion.” (Emphasis mine.) S&P wants to end the practice because it varies from bank to bank, and doesn’t provide the best way of assessing the amount the bank will actually need to pay to settle its debts.

Meanwhile, banks are able to steal enough from customers to more than cover resulting lawsuits. A judge approved a $410M settlement in a class-action lawsuit affecting more than 13M Bank of America customers who incurred debit card overdrafts during the past decade. The problem? ABCNews: “Barry Himmelstein, an attorney for customers who objected to the deal, said he calculated that the bank actually raked in $4.5B through the overdraft fees and was repaying less than 10 pct. He said the average customer in the case had $300 in overdraft fees, making them eligible for a $27 award — less than one overdraft charge — from the lawsuit.” — 11/8/11

Insiders Bailing

CNNMoney: “Insider selling accelerated in October to the most aggressive pace since February. That follows the S&P 500’s gain of 11 pct — its best monthly performance in almost 20 years.

“In fact, there were almost $19 worth of insider stock sales in October for every $1 of insider buys, according to market research firm TrimTabs. That was way up from near record low levels of insider selling — between $2 and $4 of sales for every $1 of insider buying — in August and September.” — 11/8/11

Stocks Still Overvalued

John Hussman writes: “Our broadest models continue to imply a probability of oncoming recession near 100 pct. … While Wall Street remains effusive about stocks being cheap on a ‘forward operating earnings’ basis, that conclusion rests on the assumption that profit margins will sustain record highs more than 50 pct above their historical norms into the indefinite future. That assumption is terribly at odds with historical evidence (as it was in 2007 when Wall Street was gurgling exactly the same thing). Given that stocks are a claim on a very long-duration stream of deliverable cash flows, our money is clearly on more thoughtful and historically reliable valuation methods. …

“In our view, investors should presently hold risky assets only in the amount they would be willing to hold through the duration of significant downturn, without abandoning them in the interim. … We emphatically don’t need to wait for the world to solve its problems before being willing to accept risk. What we do need is for those risks to be more appropriately priced in view of those problems. We’re not there by any means, but a significant change in the market’s return/risk profile could come quickly. To quote MIT economist Rudiger Dornbusch (who was a professor to the new head of the ECB, Mario Draghi), ‘The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.'” — 11/8/11

Train Wreck Priced In

Scott Minerd, chief investment officer at Guggenheim Partners, told the New York Times, “We’ve reached a stage where we all understand that a train wreck of some sort is coming. The question is what will the wreck actually look like, how much damage will it do, and the markets have already priced in a lot of damage.” He expects worse to come from the Greek crisis, but thinks it might not be as bad as the market believes.

Elsewhere in the Times, Gretchen Morgenson finds two lessons in MF Global’s blow-up: “The first is that our financial institutions are not impervious to Euro-shocks. The second is that when those problems reach our shores, they usually ride in on a wave of derivatives.” The problem with credit derivatives is “risks that can be hidden from view, and risks that are not backed by adequate postings of collateral.” Yes, those are the same problems that sank AIG. Too bad net credit default swaps on debt issued by France total $24B today compared to $14.4B a year ago. Italy weighs in at $21.2B, Spain $17B, and Greece $3.7B. — 11/7/11

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